After The S&P Downgrade, Time To Buy Financials?

Financials have been the disaster of 2011. Their market caps were slashed by significant amounts in 2011, primarily due to eurozone concerns. While major European Banks were the biggest losers, the panic in the sector was contagious. Bank of America (NYSE:BAC) lost 62%; JPMorgan (NYSE:JPM) lost 31% and Citibank (NYSE:C) lost 47% in 2011. Even banks that have strong balance sheets with minimal exposure to risky assets, such as Wells Fargo (NYSE:WFC), could not resist the bearish outlook in the sector. Wells Fargo, a Warren Buffett favorite, lost 22% in 2011.

I have been looking for a signal of recovery to buy some financials for a while. They are trading at their historically low, single digit, P/E ratios. Surely the dividend cuts by major banks were a colossal disappointment for income-oriented investors, but banking stocks look insanely cheap after losing almost half of their market caps since January.

While I was looking for an appropriate entry level, the Standard & Poor’s downgrade of 15 major banks added more doom to an already gloomy atmosphere. According to the Standard & Poor’s recent press release, the company reviewed several mega-cap banks. Based on the new rating criteria, S&P downgraded 15 major banks that operate primarily in the U.S. and Europe. What is quite intriguing is the way S&P lags the markets when it comes to downgrading these stocks. Here is the recent performance review of major U.S. and European banks that have been subject to S&P’s negative grading:

As one can see from the table above, the major banks, which were recently downgraded by S&P, were already smacked by the market. The average year-to-date returns of the major U.S. and European Banks downgraded by S&P is -42%. The S&P downgrade was probably right, but it came at a time when these stocks were already trading near 52-week lows.

Among these financials, Bank of America is the biggest loser of 2011. The bearish investor sentiment has driven the stock all the way down near $5. This level is a major emotional and technical support level for the BAC holders. If the news turns out to be good, we might experience a fast recovery in the stock, doubling the price in a short period. However, if things get more complicated within Bank of America’s already complicated balance sheet, the stock might keep falling for a while.

One should note that Bank of America’s case does not necessarily apply to other major institutions. Banks such as JP Morgan Chase and Wells Fargo have solid balance sheets with strong fundamentals. JPM has a net profit margin of 20%, and the company was able to boost its EPS by 77% in this year. Similarly, Wells Fargo is also highly profitable with a net profit margin of 19%. Its EPS increased by 26% in this year.

Consider another financial: Bank of New York Mellon. At a price of $18, Bank of New York Mellon is trading lower than its mid-crises prices. Thus, the stock is already priced for a 2008 type of disaster. The company supports a yield of 2.88% with a low payout of 20%. Insiders are quite bullish on the stock, making several purchases in recent periods.

While the U.S. banks are obviously priced for the near-worst case scenarios, it is quite hard to say much about the future of European banks. The European banks might have substantial exposure to Greek bonds, a significant portion of which is expected to be defaulted. Probably, these banks will be able to digest the related costs of a Greek default, but the real concern is what might happen if Spain or Italy follows Greece? Therefore, unlike their U.S. counterparts, I think the concerns about European financials are well-founded.

Summary

Most major banks that were subject to the S&P downgrade are trading near their mid-crises levels, offering a deep value for risky investors. As the legendary investor Warren Buffett suggests, bad times offer good business opportunities. Whenever there is extreme pessimism and uncertainty, investors tend to make the wrong decisions. The S&P downgrade should not deter risk-willing investors from taking positions in cheap U.S. financials. It is quite hard to time the market, but this time of the year is usually the best time to go long in equity markets. I still cannot suggest where a portfolio of U.S. financials will be next week, but I am positive that they will provide nifty returns over the next years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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